An annuity is an insurance product that pays out income and is often used as part of a retirement strategy. Annuities are a popular choice for investors who want to receive a steady income stream in retirement. Here’s how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment.
There are two basic types of annuities: deferred and immediate. With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement. If you opt for an immediate annuity you begin to receive payments soon after you make your initial investment. The deferred annuity accumulates money while the immediate annuity pays out. Deferred annuities can also be converted into immediate annuities when the owner wants to start collecting payments. Within these two categories, annuities can also be either fixed or variable depending on whether the payout is a fixed sum, tied to the performance of the overall market or group of investments, or a combination of the two.
One of the main benefits is that the money that you invest in an annuity grows tax-deferred. All the money you invest compounds year after year without any tax bill. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.
In addition, annuities allow you to put away a larger amount of cash and defer paying taxes. Unlike other tax-deferred retirement accounts such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement, which makes annuities particularly useful for those that are closest to retirement age.
When you cash out, you can choose to take a lump-sum payment from your annuity, but many retirees prefer to set up guaranteed payments for a specific length of time or the rest of your life, providing a steady stream of income.
Like most financial products, annuities carry with them their own set of disadvantages, chief among them are the fees, which can include commissions, surrender charges and high annual fees. All told, you could be paying 2% to 3% a year, if not more. This is nearly double the management fee charged by the typical actively-managed mutual fund.
The annuity industry has also had to deal with accusations of unscrupulous sales agents and shady marketing practices.
This led Stan Haithcock to write in a September 2013 article in the AAII Journal that “…annuities are the curse word of the financial world.”
That hasn’t stopped consumers from buying hundreds of billions of dollars of annuity products each year. According to its “U.S. Annuity Sales Survey,” LIMRA Secure Retirement Institute found, including all categories, annuity sales were $53.6 billion during the third quarter of 2016, down 11% from last year, representing the second consecutive quarter of declines for overall annuity sales. To date this year, annuity sales have declined 2% to $170.9 billion, according to LIMRA.
According to the survey, fixed indexed annuity (FIA) sales reached $15 billion during the third quarter, up 5% from last year, and to $46.9 billion for the first three quarters, up 22% from a year ago.
AAII Weekly Survey Question
To see how our readers view annuities, we posed the following question to them last week:
What is your impression of annuities?
Here is how they responded:
An overwhelming majority of our readers–76% of the 2,833 respondents–have some type of unfavorable impression of annuities. Specifically, 43% of all respondents have a very unfavorable impression and another 33% have a somewhat unfavorable impression.
Another 10% of our readers have a neutral impression of annuities.
Only 12% have some type of a favorable impression–9% somewhat favorable and 3% very favorable.
Weekly Special Question
To gain better insight into what or readers perceive as the biggest advantages and disadvantages to annuities, last week’s special question asked:
What do you see as the biggest advantages AND disadvantages of investing in annuities?
As several readers pointed out, the wording of the question was imperfect, as annuities are more insurance products that they are investments. Others alluded to the intentional vagueness of the question, given the many flavors of annuities that are available.
This special question garnered one of the highest response rates we have seen. In all, 424 readers offered their opinion.
We analyzed the responses and broke them into broad “advantages” and “disadvantages” categories and then tried to group them into more narrow answer grouping.
By nearly a two-to-one margin (501 versus 247), the disadvantages our readers see with annuities outnumbered the advantages.
By far, the biggest advantage our readers listed for annuities was the secure/steady income stream that annuities offer, garnering 71% of the “positive” responses. In a distant second was the easy asset allocation annuities offer with just over 11% the “advantages” votes.
In third place as far as the advantages of annuities is the downside protection they offer. In all, slightly more than 8% of respondents listed this as an advantage of annuities.
On the “disadvantages” side of the ledger, the most dominant theme was the high commissions, management costs and surrender fees associated with annuities, receiving almost 41% of the “negative” votes. Next came the relatively low returns and yields commonly associated with annuities, especially in the current low-interest-rate environment, receiving nearly 15% of the “disadvantage” responses. Lastly, the inability to access capital once “annuitized” was the third-most-mentioned disadvantage of annuities, receiving close to 11% of the “disadvantage” responses.
Here is a sampling of the responses:
- “The only reason that I can see for owning an annuity is to have a secure income stream so as to allow one to remain heavily invested in stocks without fear of downturns. The downside, of course, is [the] lack of control over your money and associated fees.”
- “[Annuities] protect our money from market declines just as bonds would while providing for modest growth. Plus, by annuitizing, my wife can start a cash flow easily in case of my death. A big negative is that companies can lower the cap on your return and high surrender charges can prevent switching to another alternative.”
- “No need to spend time on asset management…”
- “While annuities offer protections they are not always a good bargain.”
- “If not inflation adjusted, an erosion of value over time.”
- “If one is too unintelligent to manage his own money it’s an advantage.”
- “How can I trust an investment that requires reading a 75-page-plus document?”
- “The biggest advantage of investing in annuities is that you don’t have to know anything about them to invest in them because if you did, you’d never do it. You’re giving someone else your money to give back to you over time, and they’re going to make a pile of money with your money in the process of doing so. So, why not get smart, do a little research and invest your own money. That’s what AAII helps you with in the first place.”
- “In my mind, the greatest disadvantage is that for the first 10 years or so I am being paid with my own funds which could have been invested to provide me a potentially better return.”
- “Disadvantage: Loss of principal to heirs if one dies too soon after purchasing the annuity.”
Everybody has an opinion! Why not give us yours? Participate in our weekly member poll, updated every Monday, and see the results online at http://www.aaii.com/memberquestion.